Week - 1

INTRODUCTION TO RISK AND

DERIVATIVES
RISK  What is Risk?
 Chances of getting injury, loss or damage
to the tangible or intangible asset may be
termed as risk.
 In Finance it can be referred as: “The
probability that an actual return on an
investment will be lower than the
expected return.”
Types of Risk

 What are the types of risk confronting a business decisions?

 Risk that is related to the underlying nature of business and deals
with such matters as the uncertainty of future sales or cost of
inputs, these risks are called Business Risk.

 Another class of risk deals with the uncertainty such as interest

rates, exchange rates, stock prices or commodity prices. These risks
are called Financial Risk.
 Re-visiting some important Terms

 Asset: “An item of ownership having positive value”

 Liability: “An Item of Ownership having negative value”

 Instrument: “A term commonly used for describing either an

Asset or Liability”
Financial Markets

 Financial market is a place where money as well as

monetary claims are traded.
 Money markets

 Capital markets

 Foreign exchange markets

Money Market

It is a place where liquid funds or highly liquid securities are

traded for short duration. Banks and financial institutions are
the main participants of this market.

Call Money Market: It is a market where surplus cash of banks

and corporate houses are traded for a very short duration.

Gilt Edged Securities Market: It is a market where government

securities are traded
 Capital Market

 Primary Market

 Secondary Market

 Spot Segment

 Derivative Segment
“The range of a derivatives contract is limited
only by the imagination of man”
--Warren Buffett
Introduction to Derivatives
 Innovation is the hallmark of financial markets around the world.

 The world financial markets have undergone a structural

transformation in the last 40 years.
 The simple world of stocks and bonds seems almost quaint
alongside the dazzling, fast paced, and seemingly arcane world of
futures, options, swaps and other innovative financial products
 Derivatives Explained

In broad term ‘Derivative’ indicates that it has no

independent value i.e., its value is entirely derived from

the value of the underlying assets.

 Derivatives explained
 Trading the right / obligation / alternative to buy or sell an
underlying asset i.e.,
 Commodity

 Equity

 Bonds / t-bills

 Foreign currency

 Interest rate

 Market Index
 As per the Regulations issued by the Bombay Stock Exchange for regulating
the derivatives trading at the BSE “Derivatives”, “Derivatives Contract” and
“Derivatives Instrument” have one and the same meaning and includes -

 a security derived from a debt instrument, share, loan, whether secured or

unsecured, risk instrument or contract for differences, or any other form of

security;

 a contract which derives its value from the prices, or index of prices, of

Underlying Securities,

 The settlement of which shall be carried out in such manner as is provided

by or under these Rules, Bye-laws and Regulations.

 The International Accounting Standard No. 133 issued by the Financial

Accounting Standard Board USA defines Derivatives as:

An instrument having following characteristics:

 A derivative’s cashflows or fair value must fluctuate or vary based on the

changes in an underlying variable.

 The contract must be based on a notional amount of quantity. The notional

amount is the fixed amount or quantity that determines the size of change
caused by the movement of the underlying.

 The contract can be readily settled by net cash payment

 History of Derivatives

 Evidence of derivative markets involving futures and

options stretch back to the ancient times.
 There are also some findings which suggest that the
forwards trading existed in India as far back as 2000 B.C.
and also some form of forward trading also existed in the
Roman times.
 Global Derivatives Markets

 According to the most recent data from the Bank for International
Settlements (BIS), for the first half of 2019, the total notional
amounts outstanding for contracts in the derivatives market was an
estimated $640 trillion, but the gross market value of all contracts

to be significantly less: approximately $12 trillion..

Derivative market in India
 1995 – amendment in securities act
 1998 – report of L C Gupta committee

 May 25, 2000 – allowed index futures

 June 12, 2000 – NSE commences nifty futures

 June 4, 2001 – nifty options
 July 2, 2001 – stock options
 November 9, 2001 – stock futures

 August 29, 2008 – currency derivatives

 August 31, 2009 – interest rate derivatives
 Basic terminology

 Derivative market: Over The Counter and Exchange traded

 Cash market (spot market / capital market) and derivatives market

 Short and long position

 Spot price

 Forward / future price

 Strike price

 Expiration date (settlement date) - European and American options

 Contract size and contract value

 Margins

 Settlement – physical and cash settlement

 Marking to market (M2M) – squaring off & margin

requirement
So, What are Derivatives?

 A derivative contract is a delayed delivery agreement

whose value depends on or is derived from the value
of another, underlying transaction.
 Types of derivative

 Forward: “A forward contract is an agreement between two parties to buy

or sell, as the case may be, a commodity (or financial instrument or

currency) at a pre-determined future date at a price agreed when the

contract is entered into”

 Futures: “A futures contract is a contract to buy or sell a standard amount

of a standardized or pre-determined grade(s) of a certain commodity at a

pre-determined location(s), on a pre-determined future date at a price in

future”
 Options: “The Holder of an option has the right to

buy or sell an ‘asset’ (the underlying) at some time in

future at a fixed price, but does not have to exercise

this right, and this is key distinction between options

and forwards/futures contracts”.

Swaps Defined

 Swaps – (Plain Vanilla): Exchange of series of

similar Cash flows between two parties.

Swaps

 The Swap contract is the binding on two counterparties to

exchange two different payment streams over time, the
payment being tied, at least in part, to subsequent- uncertain
– market price developments.
 Swap transactions started in their present form in 1981 with
currency swap transaction.
Swaps

 The main reasons for swap transactions are:

 Barter
 Arbitrage
 Liability Management
 Types of Swap Transactions

 Interest Rate Swap

 Currency Swap
“Credit Derivatives are over-the-counter financial contracts,
usually defined as off-balance sheet financial instruments that
permit one party to transfer credit risk of a reference asset,
which it owns, to another party without actually selling the
asset.”
Participant in Derivative Markets

 Hedgers
 Speculators
 Arbitrageurs
Function of Derivatives

 Transfer of Risk

 Hedging

 Price Discovery

 Improve Market Efficiency for the Underlying Asset

 Liquidity Function

 Market Completion
Criticism of Derivatives

 Increased Volatility
 Increased Bankruptcies.
 Increased Regulations.
Market Mechanism

Derivatives markets trade on margin trading system.

Traders are required to maintain their margins at all times with

the exchange.

Derivative trading is a zero sum game.

 Investment v/s Consumption assets

Investment assets are assets that are held for investment purposes. Some

examples are: Gold, Silver, Bonds , Stocks. Where as a

Consumption asset is an asset that is typically held for consumption. Some

examples are: Oil, Copper, Cattle.

Forward Contracts

“A forward contract is an agreement between two parties to

buy or sell, as the case may be, a commodity (or financial

instrument or currency) at a pre-determined future date at a

price agreed when the contract is entered into”

Forward Contracts

 Over the counter Forward contracts.

 Long forward for fear of prices going up.

 Short forward for fear of prices going down.

 Default risk.

 Customized to suit convenience of each party.

The salient features of forward contracts
 They are bilateral contracts and hence exposed to counter–
party risk.
 Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and the asset type
and quality.
 The contract price is generally not available in public
domain.
 On the expiration date, the contract has to be settled by
delivery of the asset.
 If the party wishes to reverse the contract, it has to
compulsorily go to the same counterparty, which often
results in high prices being charged
 Limitations of forward markets

 Forward markets world-wide are afflicted by

several problems:
 Lack of centralization of trading,
 Lack of Liquidity, and
 Counterparty risk
Forward Price
 For a long position in forward Contract payoff is:

 For a short position, it is:

 = Pay-off from forward contract

 = Spot Price at the time of delivery

 K = Delivery price
 Example
Consider a one–year futures contract on gold. Suppose the fixed charge
is Rs.310 per deposit up to 500 kgs. and the variable storage costs are
Rs.55 per week, it costs Rs.3170 to store one kg of gold for a year(52
weeks). Assume that the payment is made at the beginning of the year.
Assume further that the spot gold price is Rs.6000 per 10grams and the
risk–free rate is 7% per annum. What would the price of one year gold
futures be if the delivery unit is one kg? (646904).
Futures Contract

“A futures contract is a contract to buy or sell a

standard amount of a standardized or pre-

determined grade(s) of a certain commodity at a

pre-determined location(s), on a pre-determined

future date at a price in future”

Futures

 Regulated.

 Margins.

 Default-free.

 Structured contracts.

 Structured time frame.

 Exchange-based.

 Buyer need not know seller and vice versa.

Cash Settlement v/s Physical Settlement

 In physical settlement the agreed quantity of the underlying is

physically delivered by the seller to the buyer.

 In cash settlement, no physical delivery takes place; but the seller

pays the buyer the excess, if any, of the final price of the underlying

over the agreed price as per the Forward contract. If the final price is

less than agreed price, the buyer pays the seller.

 Forward contracts can be cash settled or physically settled as per

terms.
Differences between Forwards and Futures

 Structured.

 Default.

 Time frame.

 Inability to customize.

 Margins.

 Cash settlement vs. Physical settlement.

 Market information and data.

 Market efficiency.
 Terminology used in Futures Contract

 Spot price: The price at which an asset trades in the spot market.

 Futures price: The price at which the futures contract trades in the futures market.

 Contract cycle: The period over which a contract trades.

 The commodity futures contracts on the NCDEX have one-month, two-

months and three-months expiry cycles which expire on the 20thday of the
delivery month. Thus a January expiration contract expires on the 20th of
January and a February expiration contract ceases trading on the 20th of
February. On the next trading day following the 20th, a new contract having a
three-month expiry is introduced for trading.
 Expiry date: It is the date specified in the futures contract. This is
the last day on which the contract will be traded, at the end of which
it will cease to exist.

 Delivery unit: The amount of asset that has to be delivered under

one contract.

 For instance, the delivery unit for futures on Long Staple Cotton
on the NCDEX is 55 bales. The delivery unit for the Gold
futures contract is 1 kg.
 Cost of carry: The relationship between futures prices and spot
prices can be summarized in terms of what is known as the cost
of carry. This measures the storage cost plus the interest that is
paid to finance the asset less the income earned on the asset.
 Initial Margin: The amount that must be deposited in the
margin account at the time a futures contract is first entered into
is known as initial margin.
 Marking-to-market(MTM): In the futures market, at the end of each trading
day, the margin account is adjusted to reflect the investor’s gain or loss
depending upon the futures closing price. This is called marking–to–market.

 Maintenance margin: This is somewhat lower than the initial margin. This is
set to ensure that the balance in the margin account never becomes negative. If
the balance in the margin account falls below the maintenance margin, the
investor receives a margin call and is expected to top up the margin account to
the initial margin level before trading commences on the next day markets
 Cost of Carry

Costs incurred as a result of an investment position.

These costs can include financial costs, such as the
interest costs on bonds, interest expenses on margin
accounts and interest on loans used to purchase a
security, and economic costs, such as the opportunity
costs associated with taking the initial position.
Cost of Carry

 Need for continuous compounding.

 Futures price = Spot price  Cost of carry.

 Futures price = Spot × ert

where e = the natural logarithm, (2.7128)
r = is the risk free rate of interest,
t = time of expiry of Futures contract (expressed in
decimals).
 Cost of Carry with Dividends

 If dividends are known with certainty, the Futures price can be

theoretically determined as
Futures = Spot  PV of dividends  Cost of carry
Futures = (Spot  Expected dividend) × ert

 If dividends are expressed as a yield, then

Futures = Spot × e (r d)t
where d is the dividend yield.
 If Futures price is higher than the above level, an arbitrage is
possible by selling the Futures and buying the spot.
 If Futures price is lower than the above level, an arbitrage is
possible by buying the Futures and selling the spot.
Margins for Futures

 Initial margin.

 Maintenance margin.

 Mark-to market margin.

Practice Question

 You have purchased 2 lots of Infosys futures expiring 26th August 2021.
The lot size of Infosys is 125 shares per lot. You purchased at the
current market price of Infosys is Rs. 1646. at the end of the day the
price falls to 1588 and at the end of the next day the price stays at
1654. Calculate the Mark-to-market profit/loss for both the days and
Margin requirements for both the days. You are required to maintain a
margin of 16.67%.
You have purchased 2 lots of SBI futures expiring 26 th
August, 20121. The lot size of SBI is 500 shares per lot.
You purchased at the current market price which is Rs.
424. during the day the price falls to 378 and ended the
day at 392. At the end of the next day the price stays at
442. Calculate the Mark-to-market profit/loss for both the
days. You are required to maintain a margin of 16.67% and
a maintenance margin of 10%. Will the margin calls get
triggered?
Forward Price Numerical

1. Suppose the current price of gold is $ 350 per oz, the risk-free rate for 3 months is 3% and

there are no holding cost of gold. What is the 3 months forward price of gold.
 Forward Contract Arbitrage

 Consider a three–month forward contract on a stock that

does not pay dividend. Assume that the price of the
underlying stock is Rs.40 and the three–month interest rate
is 5% per annum. We consider the strategies open to an
arbitrager in two extreme situations.
Suppose that the forward price is relatively high at Rs.43. An
arbitrager can borrow Rs.40 from the market at an interest rate
of 5% per annum, buy one share in the spot market, and sell the
stock in the forward market at Rs.43. At the end of three
months, the arbitrager delivers the share and receivesRs.43.
The sum of money required to pay off the loan is Rs. 40.50
(Spot price i.e., 40 x ()). By following this strategy, the
arbitrager locks in a profit of Rs.43.00 - Rs.40.50 = Rs.2.50 at
the end of the three month period
 Suppose that the forward price is relatively low at Rs.39. An
arbitrager can short one share for Rs.40,invest the proceeds
of the short sale at 5% per annum for three months, and take
a long position in a three–month forward contract. The
proceeds of the short sale grow to (Spot price i.e., 40 x ()) in
three months. At the end of the three months, the arbitrager
pays Rs.39, takes delivery of the share under the terms of
the forward contract and uses it to close his short position, in
the process making a net gain of Rs.1.50 at the end of three
months
Forward Contract Arbitrage Numerical

1. Consider a 6months forward contract on a bond. The spot price of the bond is $95 and that

the bond will pay a coupon of $5 in 3 months. Assuming that the rate of interest being 10%

what will be the arbitrage free forward price of the bond?

Basis Risk

 Difference between Spot price and Futures price is the basis.

 If this difference goes up, basis is said to strengthen.

 If this difference comes down, basis is said to weaken.

 Strengthening of basis is advantageous to the short hedger.

 Weakening of basis is advantageous to the long hedger.

Cross-Hedging

 Hedging with the Futures of a different underlying.

 Need to find a correlation or “Beta”.

 Basis risk is higher in cross-hedging.

 Timing and delivery issues.

 The possibility of adjusting the Hedge ratios to suit latest conditions.

Rolling the Hedge Forward

 Time horizon not matching the hedger’s requirements.

 If actual time horizon is shorter, no problem.

 If the actual time horizon is longer, hedger has to go for a Futures

contract, close it out just before expiry and simultaneously go in for the

next Futures.

 This procedure to be repeated till reaching desired tenure.

 Transaction costs likely to be higher.

 Basis risk.
Calendar Spread

 If the prices of different Futures on same underlying but expiring at

different rates are not proportionately different, the underpriced

Futures can be bought and the overpriced Futures sold.

 The hope here is that the prices will reach the “correct” levels before

expiry of the earliest Futures.

 The “correct” prices are generally the rates based on the cost-of-carry

principle.
Stock Futures

 Principles behind market index.

 Common indices.

 Methodology of construction and revision of indices.

 Market-weighted and book-weighted.

 Stock Futures as an instrument.

 Rules in NSE.
Hedging with Stock Futures

 Beta.

 Optimal hedge ratio.

Number of Futures contracts for hedging = (Portfolio Value × Beta of

Portfolio)/Value of a Futures contract

 Long the index futures and short the index futures.

 Settlement and squaring up.

Thank You